Prices are dropping. Deflation is a threat. Who for?

Raffaele Zenti Financial risk management guide Leave a Comment

In January, Christine Lagarde, the head of the International Monetary Fund, urged governments to maintain vigilance to prevent speculative bubbles and to block a threat to global prosperity: deflation.

Among the new risks for advanced economies, according to the IMF,  there is that of  “low inflation” in particular in the euro area.

We often hear about inflation and by now, we have learned that when it is too high, inflation is a problem: the prices of goods and services rise too quickly, while wages and assets lose value.

But when inflation is so low as to become even negative (and thus prices fall) this is also a problem. This situation has a name: deflation.

In the Eurozone, there is no full-blown deflation, but what is certain is that prices are rising very little, certainly at a rate much lower than the magic number, the ” target” of the ECB of 2 %. In fact, in Italy (which reflects the overall situation of the euro area quite well), between October and November, prices fell by 0.3%. And last year, the price variation was 0.7%: that is, prices have increased very little.

That’s why the risk of deflation is currently being talked about.

Now I bet you’re thinking: “If I go to the supermarket to do the shopping, I’m happy to see lower prices of the products that I buy regularly.”

According to many economists and commentators, that’s not how it is.

In short, the fear of many is that, at the lower price, you will buy less goods and services, weakening the revenues and profits of companies, which may lay off employees, close, fail (with bad consequences for the lending banks). This would weaken demand yet again, causing further price decreases and so on, creating a vicious circle.

But who knows how things actually would be in the real world, so very different from the abstract representations of the majority of economists.

Let’s keep to the facts for now:

1) in the event of deflation, the real returns of any financial instrument climb:

real returns = nominal returns – price variation

(in this case the variation of the prices is negative, therefore you add … )

2) growth in real yields is a good thing for those who have investments (because investments are growing at a higher rate) and, conversely, are negative for those who have debt (because debts rises at a higher rate).

So if you are an investor “in surplus” (i.e. if your savings are higher than any mortgages and loans you have), deflation is your friend, because it brings with it higher real yields.

So far, so simple.

The other effects, such as those on consumption and production are not deterministic, as the economy and markets are a difficult system to predict ( … I think the empirical evidence of this is incontrovertible). Let’s see some annotations to the idea that there is a collapse of consumption and production, just to provoke some healthy doubt.

First, many purchases cannot be postponed: if you don’t want to stay locked in your house with an empty stomach, no water, no heating and in the dark, you’ll have to continue to buy goods such as food, water, electricity, fuel and so on.

Then, if you think about it for a moment, in various sectors deflation is already a reality. Consider, for example, technology: the cost of hardware and software has fallen. But the consumption of technology has increased.  Samsung and Apple are able to successfully sell the latest model of their tablets, even though it is known that the price of the previous model has dropped significantly.

Also the prices of goods and services are strongly influenced by the web. For instance book and travel prices are going down. Of course, these are businesses which are being re-vamped, with new business models and new companies replacing the old ones. However, Amazon is selling books with great profits and at lower costs for us. This situation is characterized by a high rate of innovation, but the real economy is a complex system and it is difficult to say what will happen.

Moreover, after fighting deflation with little success for two decades, Japan (according to the OECD) still has an index of life quality above the world average, as well as wealth much higher than the OECD average. The unemployment rate in Japan is 4%, when in the euro area it is 12% and in the U.S. it is 7%.

The real point is that deflation is the enemy of governments, because they are almost all (much) in debt. In fact, deflation, other things being equal, leads to an increase in the debt / GDP ratio, which could become unsustainable and lead (in extremis) to default. Also, if you experienced a negative impact on consumption and corporate profits, tax revenues would also decrease.

In short, deflation is a potential disaster for the state. It is no coincidence that Christine Lagarde has defined the deflation as “the ogre we have to combat without delay”.

Price stability is definitely the most desirable situation: given the risks of deflation for sovereign states, you can rest assured that institutions (ECB in particular) will do their best to achieve it.

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About the Author
Raffaele Zenti

Raffaele Zenti

Co-founder and Head of the Financial Strategies Group of Adviseonly (www.adviseonly.com). Expert in finance and risk management. He graduated in Economics from the University of Turin, with a specialisation in Statistics. He has worked in assets allocation for Sella Asset Management, where he was head of the Financial Business Consultants unit in Engineering. Previously he worked at Allianz Global Investors Italy for ten years as Head of Risk Management and then as Head of Quantitative Management. He was recently the Quantitative Management Manager at Banca Leonardo Group and provided independent consultancy for IDeA Sim - DeA Group. He is also a lecturer in Quantitative Portfolio Management at the University of Turin Master’s in Finance programme, has published various articles in asset management and finance magazines (including the Journal of Asset Management, Economic Notes and Risk) and has contributed to books on subjects related to investment choices and Risk Management.

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